In defense of fiat money…

4 Dec

Post QE2, there has been a sharp proliferation in opinion that gold standard is the way to go. The paper money, it is alleged, has brought the world nothing but inflation and debt. Several virtues of gold standard are then highlighted.

I find the scathing criticism of paper money unjustified.

A simple look at the quantity theory of money tells us the following,

MV = PT

where, M= total amount of money in circulation

V = velocity of circulation of money

P = price level

T = amount of transactions in an economy

V is a behavioral constant.

In gold standard, M is inelastic, and given the behavioral constant V, leads to an inelastic P x T. So you don’t get inflation, but you also don’t get rapid growth in an economy as the monetary base M grounds T. T cannot increase rapidly if M remains inelastic as there is a limit to the amount of transactions a given M can support.

In the system of fiat money (paper money), M is elastic and controlled by the central bank. The increase in M (with the V constant at some level), brings a corresponding increase in P x T. Now, how much of this growth is contributed by P and how much by T is very debatable and hence an outright criticism of the paper money system is unjustified.

By making the money supply elastic, we have added to our repository a tool with which to experiment on economic growth. Sometimes, this experiment malfunctions, but suggesting a return to gold standard is like throwing the baby out with the bath water.

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6 Responses to “In defense of fiat money…”

  1. Arindam December 5, 2010 at 3:42 pm #

    Dude — you just quoted the textbooks in your defense! In the same way a lot of other textbook material can be thrown back to justify the gold standard!

    Come on Ravi — I am sure you can come up with a more interesting defense than this…

  2. Ravi Saraogi December 6, 2010 at 6:06 pm #

    @jana: hmmmm… looks like you we have a gold standard sympathizer with us.. the reason i wrote the post was that a lot of commentary on gold standard vs paper money focuses on the fact that paper money has led to rampant inflation.. everybody seems to be talking about the P…..nobody talks about the T..

    apart from the above, i value independent monetary policy… and hence support paper money… there is no ‘monetary policy’ under a gold standard system and the world reduces to a merchantilist framework where each country tries to increase its net exports in order to accumulate gold…. all this was fine in the in the past.. however, post the second world war, global economic dynamism made the gold standard obsolete and the hence the standard crumbled…

    a few example of the global economic dynamism i am referring to – japanese recovery post the second world war, economic miracle in the asian tiger economies and the chinese growth story… all not even remotely possible under a gold standard system of inelastic money supply….

    wat say?

  3. Arindam December 7, 2010 at 11:08 am #

    I am not a supporter of either standards. Both have their own pros and cons. The only reason I said what I did is because your write-ups are usually great reads and has a lot of your own analyses in them. This one sounded as if it was straight out of the macro textbook! Didn’t sound like your writing…

    But on the global economic dynamism: I recently watched a debate on TV that said that China has artificially controlled its exchange rate for the last 30 years (that is, says it’s market controlled, but maintaining the rate almost constant vis-a-vis the Dollar), and this gives it untold benefits in terms of FDI and net exports.

    Do you think either Gold Standard idea or having the freedom of monetary policy (i.e., have market controlled exchange rates) can change the dynamics that are set into motion by economically large countries, like China?

  4. Ravi Saraogi December 8, 2010 at 12:43 pm #

    Yes Jana.. We know China maintains an undervalued exchange rate.. Exports are vital to Chinese growth.. So at this stage, exchange rate and monetary policy are important for China.. Once the Chinese economy reorients itself from a export driven economy to a consumption driven economy, then the importance of exchange rate declines.. It will also relieve monetary policy of trying to achieve twin objectives of pegging the exchange rate and at the same time controlling business cycles..

Trackbacks/Pingbacks

  1. A Guide to the Gold Standard « Informed Investors - July 7, 2012

    […] to clarify through this post. On 4 December , 2010, I had put a post in this blog with the title In defense of fiat money. Much of what you will read in this post will directly contradict what was argued […]

  2. A Guide to the Gold Standard « economese - August 13, 2012

    […] to clarify through this post. On 4 December , 2010, I had put a post in this blog with the title In defense of fiat money. Much of what you will read in this post will directly contradict what was argued […]

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